Ind AS compliant entities will now adopt the new Ind AS 115, Revenue from Contract with Customers from April 1, 2018. This standard will impact all companies, with a varying degree depending on the industry sector, existing contracting practices and more importantly their existing accounting policies.
The good news – finally revenue will be recognised in the same way across the globe as it is a substantially converged standard. On the other hand, immediate adoption has left little time for implementation. The situation is further exacerbated for Phase II entities, who have recently transitioned to Ind AS and will have to transition once again to the new Ind AS 115 beginning April 1, 2018.
Let’s explore some of the significant changes.
Change From The Age-Old Transfer Of ‘Risk And Rewards’ To A ‘Control’ Model
Under Ind AS 115, revenue is recognised when control over goods or services is transferred to a customer, which under current GAAP is based on the transfer of risks and rewards. A customer obtains control when it has the ability to direct the use of and obtain the benefits from the good or service, there is transfer of title, supplier has right to payment etc. – with the transfer of risk and rewards now being one of the many factors to be considered within the overall concept of control.
Entities will have to determine whether revenue should be recognised ‘over time’ or ‘at a point in time’.
As a first step, a company will have to determine whether control is transferred over time. If not, only then revenue will be recognised at a point in time, or else over time. There are specific criteria to reach these conclusions. Take for example, an industrial and products manufacturing company that produces several specialised products to a customer’s specification, the products have no alternative use to the entity (as highly customised) and basis the payment terms the customer will reimburse costs incurred plus a reasonable profit margin for both completed units and those in production at any point in time. Under Ind AS 115, this could advance revenue recognition ‘over time’ during production, which under current GAAP would have been recognised at a ‘point in time’ upon transfer of the risk and rewards of ownership say on the installation of those specialised products.
Promises To Customers
Ind AS 115 focuses heavily on what the customer expects from a supplier under a contract. Companies will have to necessarily determine if there are multiple distinct promises in a contract or a single performance obligation (PO). These promises may be may be explicit, implicit or based on past customary business practices. The consideration will then be allocated to multiple POs and revenue recognised when control over those distinct goods or services is transferred.
In my experience, this area can be quite complex and significantly impact the timing of revenue recognition – for example, if certain elements do not meet the definition of a distinct PO, then revenue will be deferred until the control over the combined items is transferred.
For example, an IT outsourcing entity that undertakes mobilisation or set-up type preparation activity and incurs costs before getting into a steady state of providing the outsourcing service. Additionally, it may receive fees for such activity. Under Ind AS 115, such activity may not qualify as a separate PO since the customer may not separately benefit from such activity. Consequently, revenue for such fees may not be recognised but deferred, including related incremental costs subject to recoverability. Similarly, upfront joining/activation fees in the telecom sector, even though non-refundable may need to be deferred over the period during which services are provided. In contrast, take a software company that provides 1) perpetual software license, 2) installation services not involving significant customisation and; 3) 2-year post-contract customer support – in this case, each of these could be distinct POs and contract revenue to be allocated basis relative standalone selling prices.
Contingent And Non-contingent Consideration
Entities may agree to provide goods or services for consideration that varies upon certain future events which may or may not occur. This is variable consideration, a wide term and includes all types of negative and positive adjustments to the revenue. Some of these concepts are new for us, especially estimating upward adjustments to revenue, something we are not used to.
This could result in earlier recognition of revenue compared to current practice – especially impacting industries where revenue is presently not recorded until all contingencies are resolved.
Consider for example an engineering, procurement, construction (EPC) company that enters into a 15 months contract to construct a manufacturing plant, with a provision that if the project is completed three months early, the customer will provide an award fee or bonus equal to 20 percent of the contract value. Under Ind AS 115, if the EPC company is able to conclude basis past historical experience of completing similar projects that it is highly probable that significant amount of cumulative revenue is not likely to be reversed in future, then the EPC company should recognise 120 percent of the contract value as the underlying services are getting transferred.
Similar situations could also arise in pharma companies licensing their drug compounds for an initial fee and development milestone payments linked to success with clinical trials and/or regulatory approvals. In such cases, based on specific facts and circumstances in addition to the initial license fees, the pharma company may be able to recognise some of the contingent fees earlier under Ind AS 115 as compared to current GAAP. Other examples of variable consideration include volume and cash discounts, refund rights, rebates, right of returns, etc., which will all be an adjustment to revenue.
Revenue from licensing of intellectual property would now change. Again it will need to be determined whether the license transfers to the customer ‘over time’ or ‘at a point in time’. A license that is transferred over time allows a customer access to the entity’s IP as it exists throughout the license period – such revenue is recognised over time as the licensor performs activities that significantly affect the IP and expose the customer to the effects of these activities during that period. Examples include retail franchises, popular brands, trade names, trademarks etc. On the other hand, licenses transferred at a point in time allow the customer the right to use the entity’s IP as it exists when the license is granted.
The customer must be able to direct the use and obtain substantially all of the remaining benefits from the licensed IP to recognise revenue when the license is granted.
Examples include licensing of product formula, IT software, completed media content etc.
In respect of licensing arrangements, the timing of cash flows i.e. up-front or over a period of time or whether it is a perpetual or a term license, may no longer be the deciding factors. For example in case of a 10-year consumer food franchise arrangement where the entire franchise fee is collected upfront, under Ind AS 115, revenue will get recognised over the 10-year period where it is concluded to be a right of access to IP. On the other hand, consider a software entity that enters into a 2-year term license for its software product with no other POs and consideration being collected over 2 years – here if concluded to be a ‘point in time’ license, then the entire 2-year term discounted cash flows will get recorded as revenue on day one when the control over license is transferred.
Time Value Of Money
Under Ind AS 115, entities will have to adjust the transaction price for the time value of money. Where the collections from customers are deferred the revenue will be lower than the contract price, and interestingly in case of advance collections, the effect will be opposite resulting is revenue exceeding the contract price with the difference accounted as a finance expense.
This may impact entities having significant advance or deferred collection arrangements e.g. real estate infrastructure, EPC, IT services, etc.
Improved, Though Increased Disclosures
Extensive disclosures are required under Ind AS 115 to provide improved insight into both, revenue recognised and future revenue from existing customer contracts, including reconciliations of contract assets and liabilities balances. Additionally, companies will have to provide disaggregated revenue information e.g. by product lines, services, geographies, type of contract fixed price or time and material, basis information reported internally to the chief operating decision maker for evaluating performance and externally in the earnings release, investor presentations etc. Companies should give this the desired and timely attention.
Way Forward: Organisational Impact Beyond Accounting
As you may note, the new standard can result in both increases and decreases in previously reported revenues. But importantly entities will have to closely analyse their business practices within the revenue cycle including changes to customer contracts, IT systems, tax implications, the introduction of new processes or controls, changes to management KPIs, disclosures and broader stakeholder communication.
Finally, companies will have to disclose the possible impact this new Ind AS will have on its financial statements in their imminent March 31, 2018, year-end reporting itself.
Sumit Seth is Partner at Price Waterhouse & Co.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.